Introduction to Corporate Finance

4: Valuing Bonds

d Which bond’s price is most sensitive to interest rate movements? Does this answer surprise you?

Why or why not? Can you explain why this bond’s price is so sensitive to rate changes?

e Which bond’s price is least sensitive to interest rate movements? Explain.

P4-13 The nominal interest rate is 9% and the inflation rate is 7%. What is the real interest rate?

TYPES OF BONDS

P4-14 Suppose investors face a tax rate of 40% on interest received from corporate bonds. Further
suppose AAA-rated corporate bonds currently offer yields of about 7%. Approximately what yield
would AAA-rated tax-free bonds need to offer to be competitive?

P4-15 Investors face a tax rate of 33% on interest received from corporate bonds. If tax-free bonds
currently offer yields of 6%, what yield would equally risky corporate bonds need to offer to be
competitive?

P4-16 You purchase an Australian government capital indexed bond at face value of $100. The bond
offers a coupon rate of 6% paid semiannually. During the first six months that you hold the bond,
prices in Australia rise by 2%. What is the new par value of the bond, and what is the amount of
your first coupon payment?

P4-17 A zero-coupon bond has a $100 face value, matures in 10 years, and currently sells for $781.20.

a What is the market’s required return on this bond?

b Suppose you hold this bond for one year and sell it. At the time you sell the bond, market rates

have increased to 3.5%. What return did you earn on this bond?

c Suppose that, rather than buying the 10-year zero-coupon bond described at the start

of this problem, you instead purchased a 10-year 2.5% coupon bond. (Assume annual

payments.) Because the bond’s coupon rate equalled the market’s required return at the

time of purchase, you paid face value ($100) to acquire the bond. Again assume that you

held the bond for one year, received one coupon payment, and then sold the bond, but

that at the time of sale, the market’s required return was 3.5%. What was your return for the

year? Compare your answer here to your answer in part (b).

BOND MARKETS

P4-18 A corporate bond’s price index is quoted as 98.110. What is the price of the bond if its face value is
$100?

P4-19 A corporate bond’s price index is listed at 102.801. It matures in three years, has a coupon rate of
5%, and pays interest semiannually. What is the bond’s YTM?

THE TERM STRUCTURE OF INTEREST RATES

P4-20 A one-year government security offers a 4% YTM. A two-year government security offers a 4.25%
YTM. According to the expectations theory, what is the expected interest rate on a one-year
security next year?

P4-21 A one-year government short-term bond offers a 6% yield to maturity. The market’s consensus
forecast is that one-year government bonds will offer 6.25% next year. What is the current yield on
a two-year government bond if the expectations theory holds?

See the problem 4-20 and

solution explained step by

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SMArT

SOLUTIONS